What Is Marginal Profit?

What Is Marginal Profit?

Let me explain marginal profit directly: it's the profit you earn when your firm or you as an individual produce and sell one additional unit. The term 'marginal' points to the extra cost or profit from that next unit. You'll see marginal product as the additional revenue from it, and marginal cost as the added expense to make it.

Marginal profit comes down to subtracting marginal cost from marginal product, which is also called marginal revenue. As a manager, you can use this analysis to decide if you should ramp up production or pull back, even hitting what's called the shutdown point where you stop altogether.

In standard economic theory, you maximize your overall profits when marginal cost matches marginal revenue, meaning marginal profit hits exactly zero.

Key Takeaways

Here's what you need to grasp: marginal profit is the boost in profits from making one more unit. You calculate it by subtracting marginal cost from marginal revenue. This kind of analysis helps you figure out if you should produce more or less output.

Understanding Marginal Profit

Marginal profit stands apart from average profit, net profit, or other profitability metrics because it zeros in on the money from one extra unit. It considers how production scale affects costs—as your firm grows, costs shift, and depending on economies of scale, your profitability might rise or fall with increased output.

Economies of scale happen when marginal profit grows as you scale up production. But eventually, it hits zero and goes negative beyond optimal capacity, leading to diseconomies of scale.

That's why companies push production until marginal cost equals marginal product, landing at zero marginal profit. At that point, there's no extra profit from another unit. If marginal profit dips negative, you might scale back, pause, or exit the business if positives don't return.

How to Calculate Marginal Profit

Marginal cost, or MCMC, is what it costs to produce one more unit, and marginal revenue, MR, is the revenue from selling it. So, marginal profit, MP, equals MR minus MCMC.

In competitive microeconomics, firms produce until marginal cost equals marginal revenue, leaving zero marginal profit. In perfect competition, prices get driven to marginal cost, so MC equals MR equals price. If you can't compete and face negative marginal profit, you'll likely stop production. Profit maximization happens where MC equals MR and marginal profit is zero.

Special Considerations

Remember, marginal profit only shows the gain from one more item, not your firm's total profitability. You should stop production when making another unit starts cutting overall profits.

Variables in marginal cost include labor, supplies or raw materials, debt interest, and taxes. Don't include fixed or sunk costs in marginal profit calculations—these are one-time expenses that don't affect the next unit's profitability.

Sunk costs, like building a plant or buying equipment, are irrecoverable, so marginal analysis ignores them. But people often fall into the sunk cost fallacy, including them and making bad decisions.

In practice, few firms keep marginal profits at zero due to market imperfections, regulations, and information gaps. You might not know real-time costs and revenues, so decisions often rely on estimates. Many operate below capacity to handle demand spikes.

Why Do Firms Care About Their Marginal Profit?

To maximize profits, you should produce as much as possible, but costs rise with output. When marginal profit is zero—meaning marginal cost equals marginal revenue—that's your optimal level. If it goes negative, scale back production.

When Should a Business Shut Down, When Considering Marginal Profit?

If marginal profit stays negative at all production levels, you should probably halt operations temporarily rather than keep losing on units.

What Are Economies of Scale?

Economies of scale occur when increasing production lowers marginal cost, boosting marginal profit as you make more units.